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Unformatted text preview: 1 Econ 513, Fall 2005, USC Lecture 7: Measurement error Here we look at the effect of measurement error on least squares estimates. In addition to classical measurement error we look at measurement error that is uncorrelated with the reported value. In addition we look at measurement error in the regressors as well as in the outcome variable. In all cases the key equation is the omitted variable bias formula. Let X * denote the true value of a variable of interest, and X the recorded value. The measurement error is the difference between the recorded and true value: X- X * . (1) The standard Classical Measurement Error (CME) model, assumes that the measurement error is independent of the true value ( X * ). Assuming that the measurement error has mean zero, this implies E [ | X * ] = 0. This model is typically defended by reference to physical measurement models where often passive recording of measurements based on imprecise measuring instruments takes place. The alternative model, which we refer to as the Optimal Prediction Error (OPE) model, is based on the assumption that the measurement error is independent of the reported value ( X ). This implies E [ | X ] = 0. An argument in support of this model views the agent reporting the data as fully aware of the lack of precision of the measuring instrument. Suppose the agent is asked to provide the value of some variable. The agent has no way of ascertaining the true value X * of this variable, but has available a flawed or noisy measure, X = X * + X , with the measurement error X independent of the true value of the variable, exactly as in the CME model. However, suppose that the agent is aware of the lack of precision of the measurement, and corrects for this by reporting the best estimate of the underlying true value X * based on this measurement X . To operationalize this we interpret best in terms of a quadratic loss function, which implies the agent would report the expected value of the true value given the agents information set. An alternative would be to assume absolute value loss, in which case the agent would report the median of X * given the information set. For most of the illustrative calculations below the mean and median will give the same answers because we assume normality. Under this interpretation the error = X- X * should have mean zero given the information set of the agent. Since the reported value is clearly in the information set, this implies that the error has mean zero given the reported value. A crucial ingredient in the OPE model is the information set. It may be that the respon- dent only has a single unbiased measurement of the underlying true variable. Alternatively, other variables, which themselves may enter the econometric model of interest, may be used to produce this estimate. (For example, Ashenfelter and Krueger (1994) survey twins and 2 ask each sibling to report both their own education and their siblings education. To the ex-ask each sibling to report both their own education and their siblings education....
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